Flowserve Corporation (FLS) Earnings Call Transcript & Summary

All right. Thanks for sticking around for day 3, last meeting of -- at least last presentation of the day. I think someone is still going. I'm John Thornton, industrial specialist here at Citi and I'm joined with Amy Schwetz from Flowserve. I've got a series of questions, and I'll open it up to the floor at various times to see if anybody else wants to lob in joining the discussion.

I'm going to be really honest, too, because I've got blinding lights in my face, so I'm...

And so you can't see who is asking. So I get -- I've got a series of questions prepped. I'll get started and then we'll make our way around. So let's start with, I guess, taking a look back at 2022, which kind of had been a challenging year, a lot of headwinds for Flowserve and actually many other companies as it relates to the supply chain. So I guess, let's start with what lessons have you learned and having faced all these headwinds, how would you characterize the supply chain labor headwinds currently? And have you adjusted your strategy as we think about 2023?

Sure. So I think everything you said there completely resonated. 2022 was absolutely a challenging year and it started -- it's hard to believe now a year later as we think about it, 2022 started out with sort of some of our biggest challenges from a COVID perspective in terms of absenteeism. And so we saw those challenges in the first quarter, saw it difficult to kind of move what we needed to through our facilities and then the supply chain challenges really, really started picking up and became something that we really had to deal with throughout the course of -- throughout the course of 2022. The third quarter probably culminated some of the challenges that we've seen in the business. And so it was really important for us as we started the fourth quarter, that, one, we finish the year strong and we put ourselves in a position where we could really build on that performance going into 2023 and that's what we think that we did with the fourth quarter of the year. As we look at where we're at today versus kind of midway through the year, I would say stable is probably the operable word. We're still seeing extended lead times. We obviously are still feeling the impact of some of the inflationary situations around the world that we find ourselves in. But I would say it's under control. And while not always improving in everything, although I will say labor availability has gotten better for us largely, we've learned how to deal with the situation and it's not getting any worse. And so I think under that environment, with the backlog that we have in place, we're really in a strong position to deliver in 2023.

Let me just expand a little bit further on that one just because as we were talking about labor and inflation. Outside of labor, if you look at the other inflationary pressures, it seems like I've heard other companies talking about logistics kind of coming in. So if you break it down into the sub-segments outside of labor, how does the rest of the inflationary pressures look?

Sure. So I think the great thing -- if there is one great thing about this environment is that pricing has been something that we've been able to use as a tool. The inflationary impacts have been so widespread that we have had the ability to increase our prices as a result of it. And unfortunately, with what we saw last year with the supply chain challenges, we fell a little bit behind from a price cost perspective in the first 6 months of 2022. I think we finally are in a position where we've caught up on that. I think the freight and logistics story was really one that was a much bigger deal for us in the first half of the year than it was in the second half of the year. One, we saw some pricing moderate. But once again, our ability to deal with it got a lot better. So you started to figure out if you're going to need to expedite or air freight, it better be an item that's on the critical path for delivery. So are you expediting and air freighting everything or are you doing that for the critical components that you need to finish the job? And so we got better at making decisions in that environment. And as pricing came off a little bit as we got more freight carriers under contract, we saw that pricing or we saw that cost pressure reduce significantly.

Perfect. So let's move on from '22 and kind of talking to your -- you mentioned the term bookings, that's where I was going next. So over the last couple of quarters, Flowserve has seen $1 billion plus kind of in your bookings orders. Can you just kind of give some color on the pipeline, overall macro kind of end market color and -- I'm sorry, the environment over the next few quarters, how do you kind of see bookings coming -- going forward for the next few quarters?

Really strong bookings here in 2022 for us. And certainly, one of the highlights that we saw, we were at $1 billion, all 4 quarters of the year or better. We had our best bookings quarter from a dollar standpoint in the third quarter of the year, but we had one project that really dominated a lot of that favorability. We booked a $240 million job for Ramco that's going to play out over the next kind of 18 to 20 months from our portfolio. I would actually say, once again kind of around momentum, the fourth quarter of the year was probably our best bookings quarter if we look at it from a component standpoint, really about half and half aftermarket OE bookings, not a lot of large projects really in that mix. So a real indication that our run rate business is not only stable, but growing. And it gives us pretty good confidence that as we go into 2023, that we're going to continue to see positive book-to-bill quarters moving forward. From an end market perspective, we have really tried to pressure test knowing kind of the economic fragility that the world finds itself in right now. And we're going to see some of that in our end markets. We're going to see some of our end markets that may hit a little bit of a hiccup. So if we think about specialty chem and some of our general industries work, we may see -- we may see that contract a bit. But as we look at some of the major influences that we see playing out over the course of 2023 and really beyond, as we think about concepts like energy security, as we think about decarbonization and what governments really around the world are doing to influence that, we see those pieces of our end markets or those sections of our end markets really performing well and providing us the pathway to kind of long-term growth.

So I guess, just expanding on that a little further. When you talk about your clients, when you think about the bookings cadence, we're talking in the next few quarters, this is how I ask the question, how do you feel about this flowing into 2024?

So I think that what we're trying to do is really set us up for a multiyear opportunity for real top line growth. And I think that where we see the strength in the markets that is extremely achievable. So thinking about the nuclear as an example, we're seeing additional nuclear build-out in Europe. We're seeing it in other areas of the world. We're seeing nuclear plants with their lives extending. We're seeing a lot of spending in decarbonization. And so as we look at our project funnel today, which was one of your kind of initial points, we see the same size project funnel today as we did a year ago at this time. So kind of despite the fact that large project environment may be contracting a little bit, that run rate business, those mid to -- small to midsize projects are continuing at a very nice pace and we see this as a great opportunity for 2023.

Okay. I'll open up to anyone just wants to ask anything from the audience? No? So let's look at the...

Maybe one.

Hand popped up there. Okay. So let's take a quick look at the guide here. So you provided revenue guidance of 9% to 11%. Backlog is obviously at healthy levels. So what does that mean to Flowserve, should that mean Flowserve should experience a significant uptick in OE-related sales growth into kind of the double digit as aftermarket stays more consistent in that low to mid-single digit. And what does that kind of mean for the margin profile? And I have a follow-up there, but we'll start with that.

Yes. So I think one thing to keep in mind with the aftermarket growth is we've seen significant growth in aftermarket in 2022. I think that was sort of mid-teens level of growth in aftermarket. So it is coming off a tough comp to be fair. As we look at kind of our beginning backlog of $2.7-plus billion, we're anticipating over the course of 2023 that we ship or recognize in revenue about 80% of that, which is an indication that, one, we've got some pretty long live projects in our portfolio, but also that we're trying to be pretty rational and pretty reasonable about what we think we can possibly ship in the year. And what that means as we think about the size of that backlog is we've got pretty modest expectations for our book-to-bill shipments and revenue throughout the year. And so that is providing us a bit of a headwind from a margin perspective. So as we think about what's -- we're going to see margin expansion in 2023. I fully expect that margin expansion will occur. And really, that is the absence of some of these frictional items that we experienced in 2022. I think the 2 headwinds that we have to encounter in 2023 that are offsetting some of that expansion that we would expect in a normal environment is that, one, the mix is working slightly against us in our assumptions. And the second is really around labor inflation, which is something that we're anticipating is real in the current environment. And so as a result, we're anticipating our labor cost will increase in 2023.

So you answered one of the 2 follow-ups I had there was on mix already. So we'll go to the other one. When we think about just better utilization of your operations, how do you think about incremental margins for 2023?

Yes. So we had very good sequential incremental margins going from Q3 to Q4, really in both of our reportable segments. Flowserve, in the best of times has kind of been in a 40% incremental margin range. We would expect probably to moderate a bit from that in 2023, given some of the headwinds that we have, but the incrementals are something that we're watching closely internally and really using that to try and drive performance within the platforms. And certainly, if the fourth quarter is any indication when we can get the volume out, the margins do follow from that and the very nice incrementals.

So we know you've seen good momentum in energy transition-related projects and obviously, the folks investments across decarbonization, energy efficiency continues to accelerate. Could you start with how big your current activity funnel is there and can you elaborate how big the end market is for you today and how big it could be over the next few years? And there's some follow-up on that.

Yes. I think as we talk about energy transition, we can get into a debate internally. It's like do these bookings exist before or after? And now we're certainly tracking them really closely. That piece of our funnel has grown by about 60% year-over-year. So we're continuing, as we track them, as we know what those are, we're seeing a lot of momentum in the space. We think it's going to grow -- continue to grow as incentives exist in this space as well. And some of it's about how are we positioning ourselves in this market to move forward. So we know that, for example, nuclear is going to continue to be important. We know that LNG is going to continue to be important in this space. LNG has been a great area for us. In 2022, we had about $100 million of LNG bookings in 2022. We would anticipate that would continue to grow. And I think the third leg of that is really positioning ourselves for green hydrogen. And Flowserve's operated -- has worked with hydrogen for decades with our products, with refineries in the gray form. And so now it's like trying to make sure that we have the right product portfolio to play in the green hydrogen space in a major way. And the nice thing is that as we think about transition fuels, LNG and hydrogen actually requires some of the same type of technology from a pump and valve perspective in terms of cryogenics. And so it should position us well over time to deal with the transition fuel and then to deal with the next transition fuel.

And I guess, just expanding on that when you think about these kinds of projects, you just talked on a lot of new markets for you going forward. If you think of them margin-wise versus legacy business, any different puts and takes that are obvious to you?

No, I think you're obviously trying to go after markets as you are looking at what markets are attractive, you're trying to understand, can I be successful there, do I have the right product mix? Are they growing? And are they growing in a way that we can be profitable in this space. And so we've got to pick our end markets based on where we think that we can make money. And so clearly, by talking about these, we think it is a space -- we think it is a space that we can do well in from a margin perspective. Some of what Flowserve wants to do better at is making more standard products over time. So as we think about this space and the space beginning and kind of being in its infancy really allows us the opportunity to standardize our product and to get very good at making products in a similar way over and over again, which should help us expand our margins. We're never going to -- we are good engineers. I'm not personally, but Flowserve, we are good engineers and we can help -- we can help our customers solve complex problems. We're not going to stop doing that. But to the extent that we can do that in a more standard way, it's only going to help that marginality.

Let's move on to the second leg in your 3D growth strategy is digitization, where you have implemented RedRaven Technology. And you've talked about leveraging data and improving internal operations and customer experience. Can you update us on the progress there and are you seeing any benefits in terms of enhanced growth and improved profitability?

Yes. So digitization is obviously just a key theme that's running through a number of industries. And we think that we have a great product offering with RedRaven in this space. We're now at a point that we can -- that we can enable pumps, valves and seals, so across our entire portfolio. And we are seeing adoption. We'd like to see faster adoption in this space. We had a really big win in the first quarter of the year already with a water company in the U.K. that we're very excited about. I think that we're getting better. We're getting better at selling this. We're getting better at how we're monitoring. And ultimately, I think there's a double edge -- there's a double benefit to this product offering over time. One is clearly the subscription service that we have on the product and the revenue that we may -- that we'll see from that over time. But also our ability to serve our customers better in the aftermarket is clearly a play here. So the goal is to make that revenue self-sustaining from the monitoring standpoint, but then really seeing an edge as we help our customers solve problems as they arise because we should be in a really great opportunity to provide them solutions given the information that we have.

So we talked about Veresen markets already. So let's talk about the geographic mix. You obviously have a big Europe and APAC presence. How would you characterize Europe at the moment? And I guess any puts and takes, acceleration, slowdowns around the other various end markets that you'd want to dig in on?

So we had a little bit of a fallout in Europe. It's actually been a source of a number of questions that we had today as we went into the fourth quarter. That was off of some pretty tough comps. We feel like we started the year relatively well out of that geographical area. It's probably one of the question marks that we have as we make our way into 2023 in terms of how the global economy is going to perform. But right now we've been pretty pleased with how that -- how resilient that space has been. I will comment that as we look at areas of our business that are tied to GDP growth and specialty chemical being one of those that we think of, we do a lot of specialty chemical business out of Europe. And so if we were to see some contraction in that space, that may impact us going forward. Asia-Pacific has been an area where we've not seen -- where we've seen contraction in the last couple of years, really related, I think, more to COVID policies than anything else in that space. It's really just kind of slowed down activity. So that's an area that we're watching that could be something that rebounds. But as we look at other geographies, North America has been quite strong and we think that's going to continue. We've seen the Middle East perform and be quite resilient and hold up well for us from a bookings perspective. And really Latin America do quite well in the mix as well. So I think we've got some opportunities in 2023 there and we've got some areas that we're watching -- that we're watching out for.

You talked about operating margin environment improving, and you have $50 million cost out reduction plan. You ended 2022 adjusted operating margins at 6%, but recorded between 10% and 11% in Q4, although the margin was a little lower than you thought it would be when you first guided to Q4. Your sales guidance for '23 implies that sales could be in line with pre-COVID-19 levels. But it looks like you're forecasting more like an 8% margin versus a close of 10% that you recorded in 2019. So do you have a different mix, is it pass-through costs in your sales or maybe is there some conservatism regarding supply chain based on your guide there?

Yes. I think a couple of things. I mean, one, as we think about operating income, where we're really trying to drive the improvement is at the gross margin level. I think that over the last couple of years, we've done a nice job controlling SG&A. We've tried to work on our interest expense. Thankfully, we were able to lock in some of our -- some of our debt prior to the current interest rate environment. And really, our effective tax rate has come down pretty substantially over the last several years. So as we think about what is dropping down to the net income line, we really need to work on gross margins. And so we think that we've got the opportunity to expand gross margins, again, thinking sequentially through the year. We ended the fourth quarter at just shy of 29%, 28.8% gross margins. We're seeing and we're anticipating that's going to contract to less than it generally has as we move from the fourth quarter into the first quarter. And then what we're seeing is as revenue kind of takes a little bit of a fair step down, we get less leverage on our SG&A. But then as we make our way through 2023, we're going to continue to see that gross margin escalate. And as volumes increase as well, we'll see that leverage more to operating income. The headwind, again, that we're seeing as we look at 2023 is really around kind of that mix element and then the second piece being labor inflation that we've got -- that we've got applying some pressure to our margin in 2023. But the goal is, obviously, if we can exit at that 30% rate from a gross margin perspective, really having the same focus that we've had coming into this year, which has really minimized that reduction from Q4 to Q1 and use that as a strong stepping stone to continue to build on those margins.

So as you talk about margins, let's touch base on price cost quickly. So [ Scott ] mentioned, the pricing was quite competitive for projects in 2022. Has the pricing environment, I guess, improved at all as you think about 2023 and kind of what's your underlying assumptions on price cost for '23?

Yes. And I would separate this into kind of 2 distinct areas of the business. And we've talked about kind of the ability to increase price in the environment. And on our run rate business, more standard business, we've had really good success passing pricing increases on to customers in the current environment. Where we've seen a lot of competition is in these large engineered-to-order projects. And so that tends to be a very competitive cost-plus environment that we see, where oftentimes people are bidding that work with the knowledge that gives you the first leg up in the aftermarket -- in the aftermarket game. And certainly, over the course of '20 and 2021 and into 2022, we saw Flowserve and a number of competitors needing to really, one, fill capacity in plants and also trying to win that aftermarket. I think as more large projects have come into play and capacity has filled, we do see the opportunity to be more selective in terms of how we're pricing projects and really capacity is playing a role in that going forward. So our margin in backlog, I think, is in a better spot than it was last year at this time. We're going to continue to see some low-margin projects work their way out of the system in 2023. And I think that will be another kind of tailwind that we'll have going into 2024 and certainly something that plays into our margins in the back half of the year.

All right. Let's move on with free cash flow and working capital. Flowserve's one of many companies that had this pressure in 2022. So let's like fast-forward the clock to 2023. Can you just give more color on, I guess, what happened in 2022 and thinking about 2023, what does conversion look like? Do you think you can get back closer to 100% type conversion and thinking about targets for maybe 2024?

Sure. So I think you're kind. 2022 was a disappointing year from a free cash flow conversion standpoint. And 2 things, I mean, one, you've got -- we need more net income. So that was -- that's a challenge one for 2023 is start with the number at the top of the cash flow statement and grow that. And we're going to -- we're going to have more success in generating free cash flow. Working capital was a huge theme for us in 2022. So $190 million of cash for working capital during the year. And that's got to unwind. That was built across the board. It was built in inventory. It was built in AR. And so I think that as we make our way into 2023, one, I think our inventory is in a better spot than it was throughout 2022. We've got strategic inventory stocks in place to help us deliver on our backlog. And realistically, as we ramp our sales, we can't ignore working capital, we're going to need to invest some in it, but we're going to need to increase that cash conversion cycle to more moderate levels. So we will be funding growth in 2023. So I don't think we're going to get back to our kind of 100% free cash flow conversion and we're going to be funding some realignment programs as well during the year. But I think the goal is really to get to kind of 75-ish percent from a free cash flow conversion considering those items and to try to not hold it all to the back half of the year. So as I look at kind of the cadence of free cash flow and look at the investments that we had in working capital in the back half of the year and really the goal is to start the year off stronger and really aim for being at least free cash flow neutral in the first half of the year, which is something that Flowserve has not always done, but something that needs to be a goal and something that we work to achieve in terms of the cash conversion cycle of our business.

Okay. And let's jump on the topic of M&A. I got a couple of questions here, but let's start with the acquisition of Velan. This was the first acquisition in some time. Can you talk about why you're making the acquisition and what it brings to Flowserve? You've highlighted cost synergies given some footprint overlap, how fast do you think these synergies could be implemented and overall margin profile for the business seems relatively low. Can you elaborate why that is and how much opportunity there is for Flowserve to improve those?

Yes. So we're pretty excited about this, I think, for a couple of reasons. I'll get into the specifics of the transaction. But I think that just in general, in generalities, this is pretty indicative of the type of transaction that we'd like to do as a management team. So as we look at the size of -- or as we look at Velan, we see, one, it makes financial sense. I think in terms of kind of financial discipline and the multiple that we paid for the business, it is a multiple below where we're trading, which is always works out -- always works out better when that's the case. It's a business that we do see synergies by combining the 2. And I think importantly, we see really a complementary product portfolio and one that fits our 3D strategy. So as we look at what Velan is, where their strengths are, and they do have a lot of strengths from a product perspective, really areas and end markets that we're very interested in. So I've said the nuclear word a lot today. And so their capabilities on the nuclear side of the business are strong. We have nuclear capabilities in both pumps and valves, but it's different than where they play. So that's strong. Cryogenic valves, again, servicing sort of LNG markets, hydrogen in the future. That's a great addition to our portfolio and then really around defense and other severe service applications. So we see a really highly complementary fit here. We targeted $20 million of cost synergies from the acquisition. That doesn't include revenue synergies that where we'll be digging in and trying to generate those as well, particularly through our network of QRCs on the aftermarket side of the business, but we're thinking that we'll get to that $20 million run rate in the second year of the acquisition, and we're targeting EPS accretion in the first full year -- first full year following the acquisition. We're anticipating a close date kind of second quarter, towards the end of the second quarter of this year.

Okay. And just digging on that, I guess, a little bit further. I know you touched on a lot of it, when you think about the geographic exposure, both quite diverse. So does it -- I mean how I guess, where is that additive, where is it helping you when you think about the geographic mix? And then you mentioned nuclear, I guess can you dig into the technological differences and where they're adding to your portfolio relative?

Yes. So geographically, I mean, they're geographically diverse, not quite as geographically diverse as Flowserve. I think one of the areas that we're interested in is -- they've got a strong presence in France, which from a manufacturing standpoint is not necessarily always something that people are excited about. But when France is the center of the sort of the nuclear know-how in Europe, it is an important presence. They've got a strong relationship with customers there that we're excited about. I think around the world, they've got a -- they've got a great R&D center in Montreal as well as manufacturing capabilities in Canada as well. And really, aside from that, not -- it's not as sprawling of a footprint as you might anticipate. So I think that we feel good about the ability to kind of integrate and fold this into the Flowserve portfolio over time, strong commercial capabilities in the mix. So we're looking forward to it. From a capability standpoint, I think what we're seeing is the ability to have valves that are a bit more severe service that are actually in the reactor versus sometimes where we play in the mix sort of outside that is a -- that is a key differential there. And really those long service relationships that they have with their customers on the nuclear side that are really appealing to us.

Okay. And I guess the going into M&A first transaction in a while. How do you think about this as -- I mean as a signal, as a strategy shift for Flowserve kind of coming from a defensive position to becoming a more offensive and just kind of thoughts about capital deployment kind of from here?

Yes. So I will say that Flowserve has not been completely on the sidelines over the last several years. I mean, we see a number of pitch books across our desk. This is one that made sense. It definitely signals the fact that we believe we're in growth mode. And it also, I think, signals probably our philosophy around where we're at of trying to understand our portfolio, understand the markets that we want to play in, in a bigger way and trying to supplement the portfolio with those products. It's like anything else. I mean, we're going to make decisions about how we deploy capital. This is one that we think will provide really healthy returns to our shareholders. And I think that's the measure of where you need to be. You need to be somewhat agnostic about what your method of growth is, but the important thing is that you're looking for growth, you're looking for profitable growth. And so we're going to continue to test the water on things and to look at opportunities to grow the business, but we're not going to do anything silly as we do so.

To the extent you're willing to expand upon that, are there any end markets that you specifically would like to add around that? You kind of mentioned some of the capabilities that they're bringing to you, is there other white spaces that are on your mind as you think about flowing capital going forward?

So I'd say as we think about -- we think about sort of the fuels of the future, we definitely like the hydrogen space. And so Scott highlighted actually on yesterday's call, some smaller investments that we've made in this space going forward. We had the R&D acquisition from Chart late in 2022. That's an example of that around cryogenic pumps. We're also working on a cryogenic pump project, which was another purchased R&D, another joint arrangement that we have around development. So I think trying to think about that space is an important one to us. We'll look at -- we'll look at adjacencies and flow control. So areas like compression is something that over time may be interesting to us. And so there's really not one right or wrong answer here. Again, it's where we see that we can add value both to our customers and our shareholders.

I just have one last question that we're asking every other corporate, but before I go there, I will open the floor one last time to see if there's anybody from the audience. So I wonder if there's something in? No. So this is the same question we're asking everybody trying to find themes here. So what are the top 2 or 3 innovations, megatrends or structural changes affecting your company over the next 5 years? Are there any emerging industry trends that are perhaps being overlooked in the current discourse?

Yes. So I would say in terms of trends, we started -- we developed the 3D kind of strategy name because we really thought that's where the industry was going. I think kind of to break that down within diversification, water is going to be a huge trend over the next several years, probably the next several decades, frankly. And so trying to think about how we play in that space profitably is important. We've talked about some of the energy transition items and energy security that I think is -- that I think are going to be trends that are with us for the next several years as well. I would say on the manufacturing footprint side, I think this concept of regionalization is real. And as we think about how do we both kind of operate globally, but have safety nets deployed regionally is going to be important over the next several years as we've seen -- as we've seen events that were bigger shocks than we kind of knew could hit the system really between 2020 and 2022 of every different flavor.

There's nothing else from the audience. I think we can end it there. Thank you for joining us. And I guess we're going to wind down the last presentation from day 3 here at Citi. Thanks for joining us.

Thanks for having us.